Swaps

Swap is an agreement between two parties,

called counter parties, to trade cash flows
over a period of time.
Swap is the exchange of one security for
another to change the maturity (bonds),
quality of issues (stocks or bonds), or
investment objectives.
Recently, swaps have grown to include
currency swaps and interest rate swaps.
 Popular form of Swaps
• Currency swap involves an exchange of cash
payments in one currency for cash payments in
another currency.
• Interest rate swap allows a company to borrow
capital at fixed (or floating rate) and exchange its
interest payments with interest payments at
floating rate (or fixed rate).
 Structure of Swaps
Swaps are over-the-counter (OTC) derivatives.
They are negotiated outside exchanges. They
cannot be bought and sold like securities or futures
contracts, but are all unique.
As each swap is a unique contract, the only way to
get out of it is by either mutually agreeing to tear
it up, or by reassigning the swap to a third party.
This latter option is only possible with the consent
of the counter party.
 Interest Rate Swaps
An interest rate swap (IRS) is a contractual
arrangement between two counter-parties
who agree to exchange interest payments on
a defined principal amount for a fixed period
of time.
In an IRS, the principal amount is never
exchanged and therefore is referred to as a
“notional” principal amount.
 Interest Rate Swaps contd…

IRS’s do not generate new funding;

rather, they convert one interest rate
basis to a different rate basis (e.g., from
floating to fixed, or from fixed to
floating). Cash Flows on IRS are a
function of the notional principal
amount, interest rates, and time.
 Interest Rate Swaps contd…

Interest rate Swaps can be used to

converting a liability from-
– fixed rate to floating rate
– floating rate to fixed rate
converting an investment from-
– fixed rate to floating rate
– floating rate to fixed rate
 Interest Rate Swaps contd…

The counter parties to the IRS agree to

exchange interest payments on specific
dates, according to a predetermined
formula. Exchanges typically cover
periods ending on the payment date
and reflect differences between the
fixed rate and the floating rate at the
beginning of the period.
 Interest Rate Swaps contd…

Fixed and floating payments are netted

against each other to prevent redundant
transfers of cash between counter
parties; a net settlement is the only
transfer of cash, made by the owing
party on the payment date.
 Comparative Advantage Argument

4.00% 3.95% LIBOR+1%

AAACorp BBBCorp
LIBOR
Deal through intermediary
 Currency Swaps
Currency Swaps generally involve exchange of
Principals and fixed coupon payments in one
currency with the equivalent Principals and fixed
coupon payments in other currency. Currency
Swaps helps firms to transform liability in one
currency to a liability in another currency and
also, convert from an investment in one currency
to an investment in another currency
 Comparative Advantage
Argument
Can$ Sterling £

Company A 9.00% * 10.5%

Company B 9.80% 11.0% *

Company A has a comparative advantage in Can $ market

while Company B has comparative advantage in sterling
market.
11% £
9% Can $ 11% £
Company A Company B
9% Can $
 Deal through intermediary

9% Can $ 11.0% £
9% Can $ 11% £
A F.I. B
10.4% £ 9.7% Can $

Advantage to A vis-à-vis market is 0.1% and to B is

0.1% and to the financial institution 0.1% (ignoring
exchange risk). The swap deal is equally attractive to
all the parties.
 Mechanics of Swap Pricing
• Constructing a zero coupon* yield curve
• Extrapolating a forecast of future interest
rates to establish the amount of each future
floating rate cash flow
• Deriving discount factors to value each swap
fixed and floating rate cash flow
• Discounting and present valuing all known
(fixed) and forecasted (floating) swap cash
flows.
 Constructing a Yield Curve
• Build a yield curve from current cash deposit
rates, eurodollar futures prices, treasury
yields, and interest rate swap spreads. These
known market rates are “hooked” together to
form today’s coupon yield curve.
• The coupon curve is the raw material from
which a zero coupon yield curve is
constructed, usually using a method called
“bootstrapping”. This involves deriving each
new point on the curve from previously
determined zero coupon points (hence the
phrase, “bootstrapping”).
 Constructing a Yield Curve
contd..
• Zero rates are higher than coupon rates when
the yield curve is positively sloped and lower
when the curve is inverted. The gap is widest
at the far end of the yield curve.
• When rates are low and the yield curve is flat,
the difference between coupon and zero
rates will be minimal, but when rates are high
and the curve steep, the difference is
significant.
 Constructing a Yield Curve
contd..
• Because the cash flow dates of the swap to
be valued rarely exactly match the dates for
which zero curve points have been
developed, interpolation between data points
is needed to solve the problem.
• While this sounds simple, some extremely
complicated algorithms have been developed
to minimize the errors that can arise from
interpolation
 Forecasting Future Short-
Term Rates

One half of the cash flows in a simple

swap are floating rate. What makes the
floating leg of the swap hard to price is
the uncertainty of the forward rates—
only today’s floating rate is known for
certain.
 Forecasting Future Short-
Term Rates contd..
A forecast of future floating rates — a
forward yield curve of short term interest
rates—is needed before prospective
floating rate cash flows can be
generated. In fact, the forward curve is
just an extension of the zero coupon
yield curve; once the zero curve has
been developed, it easily transforms
into the forward curve needed to
generate the swap’s floating rate cash
flows.
 Deriving Discount Factors

Discount factors, used to present value

each swap cash flow, are developed as
part of the process of bootstrapping the
zero coupon yield curve. Like forward
interest rates, discount factors are just a
transformation of zero coupon rates. In
fact, there is a simple formula for
converting one to the other.
 Valuing the Swap
• With all the calculations concluded, the only
step remaining is to apply the discount factors
to find the present value of fixed and floating
swap cash flows. These values are then
netted to determine the swap’s current
market value.
• This value can be positive, zero, or negative,
depending on how market interest rates have
changed since the swap was created. For a
floating to fixed swap, higher market rates will
create a gain for the hedger, lower rates a
loss.
Valuation of Interest Rate Swaps
 Forward Curve for LIBOR
• Assume the following LIBOR interest rates:
Spot (0f3) 5.42%

Six Month (0f6) 5.50%

Nine Month (0f9) 5.57%

Twelve Month (0f12) 5.62%

Forward Curve for LIBOR contd.
LIBOR yield curve

5.62
5.57 0 x 12
0x9
5.50
0x6
5.42
spot

0 6 9 12 Months
 Implied Forward Rates
• We can use these LIBOR rates to solve for the
implied forward rates
– The rate expected to prevail in three months, 3f6
– The rate expected to prevail in six months, 6f9
– The rate expected to prevail in nine months, 9f12

• The technique to obtain the implied forward

rates is called bootstrapping
 Implied Forward Rates
• An investor can
– Invest in six-month LIBOR and earn 5.50%
– Invest in spot, three-month LIBOR at 5.42% and re-
invest for another three months at maturity

• If the market expects both choices to provide

the same return, then we can solve for the
implied forward rate on the 3 x 6 FRA
 Implied Forward Rates
(cont’d)
• The following relationship is true if both
alternatives are expected to provide the
same return:

2
 0 f 3  3 f 6   0 f 6 
1 + 1 +  = 1 + 
 4  4   4 
 Implied Forward Rates
(cont’d)
• Using the available data:

2
 .0542  3 f 6   .0550 
1 + 1 +  = 1 + 
 4  4   4 
3 f 6 = 5.58%
 Implied Forward Rates
(cont’d)
• Applying bootstrapping to obtain the
other implied forward rates:
– 6f9 = 5.71%
– 9f12 = 5.77%
 Implied Forward Rates
(cont’d)
LIBOR forward rate curve

5.77
5.71 9 x 12
6x9
5.58
3x6
5.42
spot

0 3 6 9 12 Months
 Valuation of Currency Swaps
In a currency swap the principal is exchanged at
the beginning and the end of the swap. Therefore,
currency swaps can be valued either as the
difference between 2 bonds or as a portfolio of
forward contracts
• Value of Swap (Vs) = Value of the debt security
in foreign currency (Bf) X Spot Exchange rate (S)
- - Value of the debt security in home currency
(Bh)
 Illustration
The following information is taken from the books of
a bank relating to an interest rate swap
Remaining term to maturity 3 years
Fixed rate paid by bank 10%
Floating rate received by bank 6m LIBOR
Current 6m LIBOR 9%
Market quote for 3 year swap 10.5% semi-annual vs.
LIBOR
Find out the value of the swap, if bank has received
the latest interest payment.
 Risk Behind Swaps

ƒ Floating Rates are Short Term Rates

ƒ The time horizon for the floating as well as fixed
rates may be different from that comprised in the
swap deal
ƒ The lender (outside parties) can enter into swaps
themselves if they find spread attractive, which
finally reduces the attractiveness of swaps to the
parties.
Engineering Swaps
 Illustration
Following are the rate of borrowing of companies A & B:
Currency A B
$ LIBOR+0.50% LIBOR+0.70%
DEM 5.35% 6.75%
The company B borrows dollars at a floating rate of
interest and the company A borrows DEM at a fixed rate
of interest. A financial institution is planning to arrange a
swap deal between the two companies and requires a
minimum of 50 basis points spread. If the swap is to
appear equally attractive to A and B, what rate of interest
will A and B end up paying? Ignore exchange risk.
 Illustration
Three companies X, Y and Z have come together to reduce their interest cost.
Following are the requirement of those companies and interest rates offered to
them in different markets:
Company Requirement Fixed$ $ Floating Fixed Euro
X Fixed $ funds 5.75% LIBOR + 0.90% 6.00%
Y Floating $ funds 5.25% LIBOR + 0.75% 6.50%
Z Fixed Euro Funds 6.00% LIBOR + 0.60% 6.25%
The amounts required by the companies are equal and are for three years on
bullet payment basis. You are required to arrange a swap between three
parties in such a way so swap benefit is equally divided among the three
companies.
Using Swap Rates to Bootstrap the LIBOR/Swap
Zero Curves

ƒ Consider a new swap where the fixed rate is the

swap rate
ƒ When principals are added to both sides on the
final payment date the swap is the exchange of a
fixed rate bond for a floating rate bond
ƒ The floating-rate rate bond is worth par. The swap
is worth zero. The fixed-rate bond must therefore
also be worth par.
ƒ This shows that swap rates define par yield bonds
that can be used to bootstrap the LIBOR (or
LIBOR/swap) zero curve
 Total Return Swaps

A Total Return Swap (TRS) is a

bilateral financial transaction where the
counter parties swap the total return of
a single asset or basket of assets in
exchange for periodic cash flows,
typically a floating rate such as LIBOR
+/- a basis point spread and a
guarantee against any capital losses.
 Total Return Swaps contd…

A TRS is similar to a plain vanilla swap

except the deal is structured such that
the total return (cash flows plus capital
appreciation /depreciation) is
exchanged, rather than just the cash
flows.
 Total Return Swaps contd…
A key feature of a TRS is that the parties do
not transfer actual ownership of the assets,
as occurs in a repo transaction. This allows
greater flexibility and reduced up-front capital
to execute a valuable trade. This also means
Total Return Swaps can be more highly
leveraged, making them a favorite of hedge
funds. Total Return Swaps (TRS) are also
known as Total Rate of Return Swaps
(TROR).
 Cross Currency Basis Swaps

Cross currency swaps are instruments

to transfer assets or liabilities from one
currency into another. The market
charges for this a liquidity premium, the
cross currency basis spread, which
should be taken into account by the
valuation methodology.
 Cross Currency Basis Swaps
contd…
Cross currency swaps differ from single currency
swaps by the fact that the interests rate payments on
the two legs are in different currencies. So on one leg
interest rate payments are in currency 1 on a notional
amount N1 and on the other leg interest rate
payments are in currency 2 calculated on a notional
amount N2 in that currency. At inception of the trade
the notional principal amounts in the two currencies
are usually set to be fair given the spot foreign
exchange rate X, i.e. N1 = X·N2, i.e., the current spot
foreign exchange rate is used for the relationship of
the notional amounts for all future exchanges.
Cross Currency Basis Swaps
contd…
 Exotic Swaps

• Delayed Start Swap

The delayed start swap is a regular plain
vanilla swap exchanging cash flows in one
index against cash flows in another index
with the exception that the start date of the
swap is not immediate.
 Exotic Swaps contd..
• The Collapsible Swap
A combination of a plain vanilla swap with a
swaption (~ an option on the swap) on that swap.
Swaption gives us the right but not the obligation
to enter into a swap with the same terms except
that we will be buying fixed rates and receiving
floating rates.
The cash flows will offset and the swap will be
deemed to be closed out since the swaption is with
the same financial institution with whom we have
contracted the swap.
 Exotic Swaps contd…

• Indexed Principal Swap

The indexed principal swap is a variant in
which the principal is not fixed for the life
of the option but tied to the level of interest
rates.
 Interest rate swaptions
An interest rate swaption is simply an option on an
interest rate swap. It gives the holder the right but
not the obligation to enter into an interest rate
swap at a specific date in the future, at a particular
fixed rate and for a specified term. For an up-front
fee (premium), the buyer selects the strike rate
(the level at which it enters the interest rate swap
agreement), the length of the option period, the
floating rate index (e.g. LIBOR) and tenor.
 Interest rate swaptions

The buyer and seller of the swaption agree

on the strike rate, length of the option
period (which usually ends on the starting
date of the swap if swaption is exercised),
the term of the swap, notional amount,
amortization, and frequency of settlement.
 Types of Interest rate swaptions
ƒ European Swaptions give the buyer the right to
exercise only on the maturity date of the option.
ƒ American Swaptions, on the other hand, give the
buyer the right to exercise at any time during the
option period.
ƒ Bermudan Swaptions give the buyer the right to
exercise on specific dates during the option period.
 Equity Swaps

• Total return on an equity index is

exchanged periodically for a fixed or
floating return
• When the return on an equity index is
exchanged for LIBOR the value of the swap
is always zero immediately after a payment.
This can be used to value the swap at other
times.
 LIBOR-in-arrears Swaps
Under a LIBOR Set In Arrears Swap, the fixed
side of the swap is the same, but the floating side
is different. Instead of setting the LIBOR at the
beginning of the rollover or reset period, we set it
at the END of the period. The payment is made as
normal at the end of the period, which in this case
is the same as the setting date.
– Normal: LIBOR set in advance, paid in arrears.
– LIBOR in Arrears: LIBOR set in arrears and paid in
arrears.
LIBOR-in-arrears Swaps contd..

An investor believes that LIBOR will stay

at the same level or fall over the next three
years. In this scenario, LIBOR will be
lower at the END of each reset period, than
at the BEGINNING. We could enter a Swap
where we RECEIVE 6 month LIBOR for 2
years and PAY 6 month LIBOR Set In
Arrears for 2 years.
 Constant Maturity Swap
• CMS is a variation of the regular interest rate
swap. In a constant maturity swap, the floating
interest portion is reset periodically according to a
fixed maturity market rate of a product with a
duration extending beyond that of the swap's reset
period.
• CMS are exposed to changes in long-term interest
rate movements. They are initially priced to reflect
fixed-rate products with maturities between two
and five years in duration, but adjust with each
reset period.